The growth of smart contracts in finance continues as new applications are found in tokenization, KYC, and insurance.
What you will learn
The three types of smart contracts are smart legal contracts, DAO, and Application logic contracts (ALCs)
Financial institutions use smart contracts to represent physical assets with digital tokens.
The insurance and agriculture industries use smart contracts alongside IoT devices.
Traditional finance relies heavily on paper-based systems and third-party intermediaries. These methods involve steps and people in ways that can lead to inefficiency, fraud, and a lack of privacy. Smart contracts' ability to efficiently handle automated processes makes them an ideal solution for financial services. Smart contracts in finance can help a business or individual to tokenize assets, use cryptocurrency, or automate transactions.
Still, many professionals and consumers may not understand the wealth of financial use cases smart contracts have. Smart contracts represent hope for smoother legal processes, workflow management, regulatory compliance, and clearing and settlement in the financial markets and international trade. In this article, we'll look at some examples of how these self-executing contracts and changing traditional financial models.
In many cases, smart contracts are not legally binding. Unlike traditional contracts, a smart contract is usually just computer code that can execute automatically when predetermined conditions are met. However, a subset of smart contracts can establish contractual obligations that are defined automatically within the program.
Smart legal contracts are a huge leap forward for decentralized finance applications, as these services are rarely regulated the same way as traditional finance tools. Automated legal contracts give users an added layer of safety without hiring a lawyer to write a paper contract.
Still, several challenges may arise when using smart legal contracts. Smart contracts are immutable, meaning they cannot be altered after deployment. Contract law generally allows for the parties involved to modify an agreement after a contract is signed. This isn't always possible with smart contracts.
Because smart contracts are autonomous, legal agreements may not always be enforceable. For example, if one of the anonymous users entering the agreement is a minor, the contract likely couldn't be enforced. Smart legal contracts use blockchain technology, meaning anyone can view them once they're deployed. The public nature of these contracts can be problematic for certain financial institutions. Still, when used correctly, smart legal contracts can simplify legal processes for everyone involved.
DAOs, decentralized autonomous organizations, are community-led projects with no central authority. These entities typically let users propose and vote on significant changes. In many cases, participants use a specific DAO token to vote. These tokens can be bought and sold, and their value may increase based on the project's actions. Each participant has a financial incentive to vote responsibly and do what they can to help the project succeed.
The participants' votes can be viewed on the blockchain's decentralized ledgers. There is no way for the project's creator to game the system. DAOs can be used in the financial services industry to democratize compliance checking and asset allocation. They also can give investors a viable reason to support a company or project.
ALCs work alongside IoT (internet of things) devices to link the internet with the real world. ALCs can be used to validate information shared between IoT devices.
ALCs and IoT devices are prominent in the financial industry, though users might not realize it. For example, smart ATMs equipped with sensors can inform their operators when they need maintenance. Smartwatches and other wearables often enable contactless digital payments that communicate with your bank.
In the future, we may see ALCs used to link wearables and other IoT devices with the blockchain.
Smart contracts enable financial institutions to represent physical assets with digital tokens. Gold, diamonds, and other precious materials can be tokenized and fractionalized, letting people invest in them without physical storage. Tokenizing physical goods using blockchain solutions can lead to reduced transaction costs, faster trade clearing and settlement, and more secure peer-to-peer transactions.
Asset tokenization doesn't always involve physical goods. Companies like Overstock.com have created digital dividend tokens to automate certain corporate actions and reduce administrative costs.
KYC guidelines require accounting firms, banks, and other financial institutions to try to verify their customers' identity and suitability. These checks often prevent interactions with individuals or businesses involved in money laundering or bribery. KYC can be a time-consuming, resource-intensive endeavor. Luckily, smart contracts can speed this process up exponentially.
Using privileged nodes, a company can send requests to certification nodes that check to ensure the organization has the necessary consent to receive information from another business or individual. This information can be encrypted and stored on the blockchain with stable and secure processes. Before smart contracts, this process could take several days, as the secondary entity manually sent the information or documents to the company making the request. In some cases, a third party could be required to verify the authenticity of the documents.
Smart contracts offer lower costs and faster payouts for insurance policies. Still, they aren't suitable for every type of insurance. These programs automatically execute if/and statements, making them ideal for travel insurance and similar policies. For example, automated contracts can pay insured individuals a specific sum as soon as a flight is canceled or delayed.
Smart contracts can be used alongside IoT devices for agricultural insurance, automatically paying out a specific sum in the event of a natural disaster or another covered incident.
Banks are centralized entities that provide loans and store funds for individuals and businesses. Smart contracts enable decentralized methods of accomplishing the same things. For example, smart contracts allow peer-to-peer lending, eliminating the need for third-party intermediaries. Such transactions happen instantaneously, unlike with paper-based systems, and enable flash loans that are borrowed and returned in seconds.
Companies, such as Tassat, tokenize bank deposits for secure B2B transactions on a private, permissioned blockchain. Since TassatPay doesn't use stablecoins or a public blockchain, it is inherently safer for business transactions. This is an example of implementing smart contracts in new ways.
Smart contracts enable seamless, secure transactions and various features ideal for the financial services industry. Hedera's secure distributed ledger technology, Hashgraph, offers financial institutions everything they need to automate and improve their workflow. HBAR and tokens created using the Hedera Token Service settle in seconds. Additionally, Hedera's public records let auditors, regulators, and partners verify user requests safely and transparently via smart contract.
Keeping up with KYC regulations is essential to the financial services industry. Luckily, blockchain solutions like Hedera easily let you define account-level KYC verification.